While fundamental analysis helps you identify which stocks you may want to add to your portfolio – based on factors including a company’s management, products and services, and financial data — this information doesn’t identify when it could be advantageous to enter or exit the market. Technical analysis may help you make those decisions.
The analysts who take this approach use indicators to spot market trends and predict stock price movements. All these indicators establish visual patterns that make it easier to understand and interpret what’s happening in the markets.
And because different indicators measure different variables, analysts typically base their conclusions about impending changes on a combination of signals.
Uptrend and downtrend
A key component of technical analysis is the principle that prices trend. In a trending market, prices rise to form an uptrend or fall to form a downtrend. Or, prices can move sideways, or up and down within a fairly narrow range, in what’s known as consolidation.
To confirm an uptrend or a downtrend, technical analysts recommend finding at least three examples, or data points, to support what appears to be happening. The longer the trend continues, the more reliable it becomes, and the more they expect prices to continue along the same trajectory. But no trend continues indefinitely, so analysts also look for evidence that a pattern may be about to reverse. That is, a price that has been trending up might change course and move downward or enter a period of sideways movement.
Following a trend
Analysts identify price trends by tracking changing prices over a period of time using a chart or graph. With a chart, where the horizontal axis tracks time and the vertical axis tracks the price, for example, daily or weekly prices are entered as a series of data points. Connecting the lowest price points on the chart forms a level of support while connecting the highest data points forms a level of resistance.
Uptrend lines have positive slopes, which means a line connecting the points rises from the left to the right. While security is trading along with a particular uptrend, the support level is thought to indicate the lowest prices the security is expected to reach during the trend. If the support level is broken, it could signal that the current trend will soon reverse.
Downtrend lines have negative slopes, which means that prices fall from the left to the right. When security is moving along a downtrend, the level of resistance is thought to represent the highest prices the security is likely to reach during the trend. If the resistance level is breached, it could be a sign of an impending reversal, and that prices may begin to rise.
Prices can also rise and fall within a zone created by the support and resistance levels. Analysts refer to prices that move this way by saying they are trending within channel lines.
Moving and turning
Technical analysts watch both what happens over a period of time but also what happens day-to-day. Moving averages show a security’s average value over a set period of time, assigning different weights to prices in the data set.
For instance, a simple five-day moving average assigns equal weight to each of the five days while other types give greater weight to more recent prices. Moving averages are popular tools because they make it easy to spot trends by smoothing out random price fluctuations that are typical of volatile markets.
A pivot point is a level at which prices break through a prior resistance level. Once security has breached a pivot point, some technical analysts believe it’s likely to continue increasing in value. Pivot points can also signal reversals.
For example, if the current close is higher than the high on the day with the lowest low during a downtrend, it could signal that prices may begin to rise. Some analysts warn, though, that pivot points are more significant in strong trends than in weaker ones.
Oscillators can be helpful for determining a trend’s strength and when security may be overbought or oversold. Overbought means prices may have risen too quickly and are unsustainably high. Oversold means the opposite: that prices may have fallen too quickly and are unsustainably low. As a result, if a stock is overbought, its price may begin to decline and if it’s oversold, the price may begin to rise.
Understanding Market Trends For Beginners by Inna Rosputnia
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